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Crunching The Numbers Can Tell You If Municipal Bonds Would Be A Good Investment

October 25, 2000|By Jeff Brown, Knight-Ridder Tribune.

Looking for a safe place to stash some money and still earn more than you'd get with a bank or money market fund?

Municipal bond funds are worth a close look. Many offer returns of about 6 percent. Since all or most of it is tax-free, that's like earning 8 percent or more on a taxable fund, depending on your tax bracket.

But what should you look for when hunting for a good muni fund?

Most investors look for muni funds with high yields, or interest payments. Municipal bonds don't usually pay as much as Treasury or corporate bonds. But muni yields are exempt from federal income tax, and they're usually exempt from state income tax so long as the bond was issued in the investor's state.

The higher your tax bracket, the more you benefit from a muni fund's tax exemption. So it's important to know how the yield on a muni bond or fund compares with that of a taxable bond or fund once the exemptions are taken into account.

The Vanguard Group, the fund company, suggests the following method for computing "taxable equivalent yield."

Start by subtracting your federal tax bracket from 100 percent. Then multiply the result by your state tax bracket. This gives your effective state bracket. A person in the 36 percent federal bracket and 3 percent Illinois bracket would have an effective state bracket of 1.92 percent: (100 -- 36) x 3, remembering that what you're really multiplying by is .64 since it's a percent. The effective bracket is lower than the actual bracket because of the federal tax deduction for the state tax payment.

Next, add this effective state figure to your federal tax bracket. This gives your combined tax bracket. In the example, it would be 37.92.

Subtract the combined bracket from 100 percent and divide the result into the fund's yield to get the taxable equivalent yield. If the yield were 5 percent, the taxable equivalent would be 8.05 -- 5 divided by 62.08 (100 -- 37.92).-

The taxable equivalent yield is what you'd need on a taxable bond to end up with the same amount, after paying taxes, as you'd get with the tax-free muni bond.

If you can find a taxable bond fund that yields more than this, you should invest in it rather than the muni fund.

Another consideration in picking a muni fund: What is the fund's expense ratio -- the management and other fees charged shareholders?

Muni funds charge an average of slightly less than 1 percent a year, according to Morningstar Inc., the fund tracking company. That's about half a point less than the average stock fund, which is good. But it's still worth the trouble to look for a fund at the low end. Some charge 0.2 percent or less.

Since muni funds rarely offer the big double-digit annual gains possible with stock funds, expenses are especially important. Invest $10,000 in a muni fund earning 6 percent a year and you'll have $32,000 after 20 years. If fees cut the return to 5 percent, you'll have about $26,500. By getting an extra 1 percentage point through low fees, you end up with nearly 21 percent more.

A further consideration: What's the fund's duration? This is a figure, which you can get from the fund company, based on the size of interest payments and the time to maturity of all the bonds in the fund.

The longer the duration, the more the fund's value is affected by changes in prevailing interest rates. All bonds lose value when interest rates rise, since investors don't want older bonds that pay less than new ones. On the other hand, older bonds' prices go up when interest rates fall, since they're paying more than new bonds do.

The duration figure tells how much the value of the bond fund would change. If the fund has a duration of six years, a 1 percent rise in interest rates would cause the fund to lose 6 percent of its value. If the duration were seven years, it would lose 7 percent.

Even though the bonds in the fund would continue making interest payments, the bonds themselves would be worth less. The total return -- interest payments plus price changes of the bonds in the fund -- would fall. It could even become a net loss.

The longer the duration, the greater the up and down swings as interest rates change. Investors must balance this risk against the benefit of longer durations; those funds tend to have larger yields.